Over the past few weeks, investors used to setting their economic expectations based on a "stream of anecdotes" approach have seen their economic views evolve roughly as follows:
"After a brief 'scare' during the third quarter, economic reports have come in better than expectations for weeks - a sign that the economy is on a gradual but predictable growth path; Purchasing managers reports out of China and Europe have firmed, and the U.S. Purchasing Managers Indices have advanced, albeit in the low 50's, but confirming a favorable positive trend, and indicating that the U.S. is strong enough to pull the global economy back to a growth path, or at least sidestep any downturn; New unemployment claims have trended gradually lower, and combined with a surprisingly robust December payroll gain of 200,000 jobs, provides a convincing signal that job growth is on track to improve further."
I can understand this view in the sense that the data points are correct - economic data has come in above expectations for several weeks, the Chinese, European and U.S. PMI's have all ticked higher in the latest reports, new unemployment claims have declined, and December payrolls grew by 200,000.
Unfortunately, in all of these cases, the inference being drawn from these data points is not supported by the data set of economic evidence that is presently available, which is instead historically associated with a much more difficult outcome. Specifically, the data set continues to imply a nearly immediate global economic downturn. Lakshman Achuthan of the Economic Cycle Research Institute (ECRI) has noted if the U.S. gets through the second quarter of this year without falling into recession, "then, we're wrong." Frankly, I'll be surprised if the U.S. gets through the first quarter without a downturn.
Three basic issues are at play. One is that analysts aren't making distinctions between leading, coincident and lagging data. The second issue is that there is little effort to measure the predictive strength of a given economic data point (or set of data points) in explaining subsequent movements in the economy. The third is that analysts seem to be forming expectations report-by-report (what I call a "stream of anecdotes" approach) instead of taking those reports in context of the full ensemble of data that is available at each point in time.
Let's examine the seemingly most "compelling" data point first - the fact that December payrolls grew by 200,000. Surely that sort of jobs number is inconsistent with an oncoming recession. Isn't it? Well, examining the past 10 U.S. recessions, it turns out that payroll employment growth was positive in 8 of those 10 recessions in the very month that the recession began. These were not small numbers. The average payroll growth (scaled to the present labor force) translates to 200,000 new jobs in the month of the recession turn, and about 500,000 jobs during the preceding 3-month period. Indeed, of the 80% of these points that were positive, the average rate of payroll growth in the month of the turn was 0.20%, which presently translates to a payroll gain of 264,000 jobs.
Likewise, in 5 of the past 10 recessions, the ISM Purchasing Managers Index was greater than 50 just weeks before the recession began, and the new orders component of that index was greater than 50 in most cases, immediately prior to the recession.
Very simply, neither a strong monthly employment gain nor a slight uptick in the PMI are informative signals that recession risk has eased. Both the PMI and the level of payroll job growth are what one might call "weak learners." It's not that these figures aren't useful - just that neither of them has a particularly good record by itself of signaling recessions. As it happens, a PMI below 54, coupled with year-over-year payroll growth below 1.3% is a stronger "learner" than either of the two data points individually (see the 2007 comment Expecting A Recession ). That combination - which is actually alternate Condition 4 of our Recession Warning Composite - remains in place at present, as are the other conditions in that Composite. Our more complex ensemble models also indicate strong recession risk.
The chart below provides a good picture of the behavior of non-farm payroll growth in the months before and after a recession begins, based on all U.S. postwar recessions. Notice in particular that in the month a recession starts, payroll job growth has not only been positive in 80% of cases, but has actually been higher, on average, than the three preceding months. Neither the level of job growth nor its short-term trend had any "leading" information content at all about the subsequent direction of the economy.
Notably however, the month following entry into a recession typically featured a sharp dropoff in job growth, with only 30% of those months featuring job gains, and employment losses that work out to about 150,000 jobs based on the present size of the job force. So while robust job creation is no evidence at all that a recession is not directly ahead, a significant negative print on jobs is a fairly useful confirmation of the turning point, provided that leading recession indicators are already in place.
I've discussed the "positive surprises" argument (see When Positive Surprises are Surprisingly Meaningless ) and the negative implications of the European ISM, despite last month's uptick (see The Right Kind of Hope ) in other recent comments. Suffice it to say that broadly speaking, the recent "surprises" in the data reflect minor fluctuations within overall levels that remain fairly tepid, and more importantly, that remain clearly unfavorable as an ensemble.
